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The Fed's Bank Stress Test Is Wrong

Dec. 31, 2018 3:36 PM ETJPM, BAC, WFC, C, GS, MS, USB, CMBS13 Comments
Benjamin Solomon profile picture
Benjamin Solomon


  • I believe that the Fed is well-intentioned and is unwilling to see a repeat of the Great Recession, but its Bank Stress Test is wrong.
  • Why did Quantitative Easing and Geithner’s “Wall of Money” work?
  • I explain in very simple and clear terms how an investor should interpret loss analytics, and what type of questions to ask of the CRO.
  • Can the banks hold up if we are heading into arecession?

Some Basics in Loss Analytics

Based on over a decade of my work in Commercial Mortgage Backed Securities (CMBS) and some Residential (RMBS) loss modeling, the generic loss profile is depicted in Fig. 1. Yes, I figured out how to calculate Black Swans. I have named Fig. 1, the Risk Centerfold as it depicts all useful measures of risk in relation to each other based on my first-hand experience working these metrics. Loss risk is the probability distribution of losses in dollars, given a specific reference condition, that a default has occurred and must not include $0 losses.

As Fig. 1 shows, most losses are centered around the mode or peak of the distribution. The average or mean μ loss is always to the right of this mode as depicted by 1x. Occasionally, the losses are so large (Var, CVaR & Black Swans) they can be many times greater than the mean as this distribution is skewed to the right; i.e. the right tail is very long.

VaR or Value at Risk as a Measure of Extreme Loss (MEL – my term to facilitate clarity and bury all the complexities in loss analytics) is more frequently used in trading and rarely in securitization. VaR is usually set at the 98th percentile. The mortgage securitization industry (i.e. bonds) uses a MEL of 3x. In very simple terms this MEL value is used to determine the risk capital, a financial institution needs to have available to it in the eventuality of an adverse economic environment.

This loss distribution will shift to the right in adverse times and economies. Banks and companies do fold in good times, too, you know. If this shift to the right is significant, MELs can evolve into Black Swans. The problem with Black Swans is that they are summative and tend to domino. For the

This article was written by

Benjamin Solomon profile picture
Solomon has 40+ years working in many different industries and fields, banking, stress testing, credit risk analysis, manufacturing, management consulting, decision theory, strategy, and physics with companies like UMB Bank, Key Bank, Texas Instruments, PwC, Unilever and Westport (Malaysia). At Westport, then (1995) a $1 billion port infrastructure, he invented the "7-hour Strategy" that enabled Westport to become the 6th largest port (2006) in the world. Using data modeling, in February 2007 he discovered the first formula in 334 years (1687-2021), for gravitational acceleration that does not have mass in the equation, g=τc2 (see his APEC Zoom video presentations Gravity Modification and An Alternative to Quantum Theory?). Solomon invented many new solutions, Asymmetric Information Resolution (AIR) Models, Wilcoxon Regression, Collated Distributions. Default Covered-Call Model, Capital Premium Model, Economic & Funding Statements, and the Infectious Disease LifeCycle Model (probably a first in medicine and replaces the Reproduction Model), and is researching Multiple Sclerosis symptom triggering. He showed that Black Swans can only come into effect when the restricted form of the Power Law, the Levy Distribution, is in effect. He has published 7 technical books and many peer reviewed papers and articles. Solomon has a Master of Business Studies in Banking & Finance (University College Dublin, 1995, oldest graduate finance program in Europe), a Master of Arts in Operations Research (University of Lancaster, 1982, a British Ivy League), and a Bachelor of Science in Electrical & Electronics Engineering (University of Aston, 1979). He is the Founder & CEO of the FinTech startup, Business AIR Models Inc and based on the algorithms he has developed, provides company credit risk assessment in minutes.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Comments (13)

Increased bank regulation the past 10 years has allowed tremendous growth in the "shadow banking" system, non-bank lenders, private credit hedge funds, etc. They aren't subject to that (or as much) regulation. The risks of collapse there may not be as systemic of a risk, due to being spread across a lot of little firms with high net worth investors who can ostensibly absorb the losses. But my concern with over regulating the TBTF banks without also taking action to curtail excesses in other forms of lending, would be that we allow the shadow banking world to get too big-- the outsized risks still being taken, just under a different umbrella.
Benjamin Solomon profile picture

I think the shadow banking is a good thing, since, as you said, it spreads the risk at the same time limiting this risk to a wealthier population who can absorb the losses.

Its not about how much or how little regulation we have. Our regulations need to be market savvy which they are not. Having said that I believe all financial services companies, whether shadow or not should be governed by two primary sets of regulations:

1. All financial services companies, are required to have MEL cushions, figure out their loss characteristics and publish these results, even if they are privately held as we need the visibility to prevent the domino of black swans. That is the primary regulation we need.

2. I addressed this in an earlier comment, that when a financial services company fails, if it is necessary as in the case of banks, its capital is wiped out and a new set of shareholders take over, with the stipulation that no bank can be a substantial shareholder of the new company.
Benjamin Solomon profile picture

First, I don't buy that legislation can prevent a massive meltdown like 2008.

It hasn't happened as you have shown. It just keeps politician satisfied that they have "done something" to "fix" the problem. And the record stands - the laws have failed to prevent crashes. That is like King Canute (www.medievalists.net/...) commanding the waves to go back.

The MEL cushion or bailout is a stop-gap measure. It makes unabsorbable losses absorbable but it does not change the banks risk profile, which is the shape of the loss distribution.

Breaking up the banks reduces the size of the Black Swan at each bank and gives the Fed/Govt. time to rectify bit by bit in small pieces.

The US economy is not a homogeneous structure. I found this out some years ago and the numbers I quote are from memory. The leading edge of a recession is driven by the big states, California, New York, Florida and Texas(?). Colorado lags by about 6 to 9 months. Rhode Island by about 18 to 24(?) months. All states are in between these time lags.

That gives the Fed/Govt time to resolve solvency issues small doses at a time, state by state, on a first-come-first-serve basis. Fed/Govt. takes over, and stabilizes it balance sheet. The shareholders of the insolvent bank lose everything.

The Fed/Govt. hands it off to a private investor’s group to turn the bank around. They sell the new turned-around bank to the highest bidder. The subsequent sale is a very important requirement. With the sale the Fed gets paid back its stabilizing funds with interest.

The public can see that the Fed/Govt. is handling the issues and gearing for the next bank failure. This will give the public confidence.

Bottom line we need a market mechanism that "mops up" (for the want of a better term) bank failure, without creating massive banks. As the data in my article suggests, there are no benefits to the economy to have massive banks, at worst these have massive Black Swans.
@Benjamin Solomon

You seem to be agreeing with me, but doing everything possible to convince yourself you aren't.

-- We agree that the Federal Govt is the ultimate backstop for the big banks
-- We agree that backward looking regulation has done nothing to prevent the "next crash"
-- We agree that if TBTF banks are the cause of economic black swans, then the govt should be breaking them up now instead of waiting for the next black swan

So what is it that we don't agree on?

The implication of the govt being the ultimate backstop is that they have to define what level of tail risk they can absorb, and then all your risk charts work back from there.

If you accept the implied premise of the last point, which is that many smaller banks are less vulnerable to simultaneous tail risk than a few large ones, than that change would also fundamentally change your graph of risk profile.
Benjamin Solomon profile picture

Yes, we agree don't we.

Yes, the risks will change, the tails get shorter.
Benjamin Solomon profile picture
liquorisquicker, very simply put, when a loan defaults, the bank forecloses and sells the property. If the amount owing is less than the selling price, there is no loss and the difference should be returned to the owner. If the amount owing is more, then if the loan is non-recourse, then bank absorbs the losses. That loss will always be much smaller than the original loan amount. Unless it was a predatory lending loan.

Yes, the Fed & Govt are the "lender of last recourse", but the US economy is a free market economy, there is no law that says the Fed or the Govt. should bail out the banks.

I believe that if we have another banking failure like what happened during the Great Recession, the Govt should say, enough is enough, and break up the banks. Unless the Govt. itself, push come to shove, does not believe in the free market.
@Benjamin Solomon

What we saw in 2008 is exactly the kind of cascading risk that defines black swan events. Euphoria quickly became panic, and the value of the underlying assets (houses) collapsed so what seemed like safe mortgages because disasters. It was no different that what happened in the Panic of 1893 and subsequent economic depression, except the one in the 1890s was cause by the collapse in the value of railroads. Because there was no govt (or Fed) backstop in the 1890s, unemployment got to 15-20%, there were riots in the cities, and farmers were wiped out. People starved to death. And if you had asked the bankers in 1892, I'm sure they all would have told you their loans were adequately collateralized.

So whether there are laws or not about bailing out banks, there is little choice but to in 2019 and beyond as the risk of doing nothing is worse than the cost of a bailout (politically and economically). So the govt (and Fed) are the bank backstop, like it or not. And with each event, they add news regulations / laws to try to avoid the next one.

The problem is that they keep closing the barn door behind the last horse that bolted instead of looking forward to what is likely to be the next one. I guess that is the definition of politics. If the result of the next financial black swan is to break up the big banks (I'm not sure I agree with that premise, but let's use it as an example), why aren't we breaking them up now to avoid it?
I like the thought process, but I'm struggling with the notion that Stress Tests should be aimed at the worst possible case. That would mean a capital ratio of 1:1 -- cash to cover all loans going bad. It is like telling borrowers they have to have the full value of the loan they are taking in a bank account in order to be able to borrow.

I think the statistics have to work the other way. Ultimately the Fed and the Federal Govt are the backstop for the ultimate Black Swan. What is the risk they are willing to take on, and how does that translate into the risk that the banks must take on?
It started as a very interesting article, but ended with some wrong interpretations of the graphs... US Bancorp is not high risk, high return...its payment business is high revenues/ assets.....
Benjamin Solomon profile picture
Knowledge helps !, I'm glad you have a different opinion, as a healthy functioning market requires heterogeneous investor expectations. My findings, in 1995, across 10 maybe 15 (forget exact number) stock markets around the world showed that markets crash when investor expectations homogenize. Fear is the universal homogenizer of investor expectations.

I did say that this section was a quick and dirty approach and that one has to take out the fee income. This section was written to illustrate how to infer the riskiness of a bank's assets in the absence of a working Bank Stress Test model.

Re US bank, yes, and high returns implies high risk, except in this case competitors have not figured out, just yet, how to break down the barriers that maintain these high returns for US Bank. Watch out for the new entrants.

At the end of the day you have to break out the various banking components and see what is what, and make your own decisions that match your risk profile.
Those are the worst “best fit” lines in a scatter graph I’ve ever seen.
Anybody can draw a random line anywhere and claim that point A should be below it. I’d like to see the math that created the lines. No math? No point.
To go further you could say based on the progression of graphs that MS and WF are undervalued based on a best fit rather than a baseline. Why is the baseline the baseline for value? Why isn’t revenue growth included as a forward looking indicator? So much missing.
Benjamin Solomon profile picture
I'm glad you disagree.

I did say that this section was a quick and dirty approach and that one has to take out the fee income. This section was written to illustrate how to infer the riskiness of a bank's assets in the absence of a working Bank Stress Test model.

There rest is your homework.
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